Market could retest October lows

Commentary: Insider trading expert sees market decline

BambiFrancisco

SAN FRANCISCO (CBS.MW) - Here's a syllogism to consider: Insider buying reflects confidence within the company that fundamentals are improving. Improving fundamentals lead to higher stock prices. Therefore insider buying leads to higher stock prices.

Sounds logical. But we all know it's not that easy. Other factors need consideration, such as who's buying and what's the prevailing market sentiment.

Here's one rule of thumb: Insider-buying activity, especially activity by chief financial officers, is one of the best ways to make long bets in the market, as long (this is equally as important, if not more) as bearish sentiment is high, according to George Muzea, the excitable insider-trading expert.

Conversely, lack of insider buying and more selling amid bullish sentiment is a good indication that the broad market will come down.

Guess what? I hate to let those congenitally bullish fund managers down, but the latter is exactly what's going on in the market today. That means even if the market has retraced about 30 percent of the gains made since mid-March, there could be more unraveling.

In fact, the overall market could take out the October lows, according Muzea, whose advice is worth contemplation if his successful practice is any guide. Muzea runs his own company called Muzea's Insider Consulting Services. At $30,000 annually, subscriptions are limited to some of the best-known hedge funds and institutions.

Muzea's indicators called for short-term rallies in September 2001, July 2002 and October 2002. In October, the number of positive market newsletters was the lowest level in eight years, said Muzea in his October report. That coupled with consistent buying should bode well for stocks. He was spot on.

More recently, Muzea sent a "buy" signal to his clients on March 7, which preceded the recent raging-rally in the market.

Today: insider buying down, bullishness up

In order to understand where the market is (up from recent lows struck in early March), you have to consider what drove stocks higher.

Importantly, it wasn't any real buying from insiders. And, not only are they not buying, they're selling. Insiders sold three times as much as they bought in recent weeks, according to Muzea.

This means that insiders are not as bullish about the fundamentals as the market would suggest.

Equally important, is that bullish sentiment is on the rise. "Since last Wednesday, there has been an undercurrent of those who want to be bullish," said Muzea, referring to a survey by Investors Intelligence that showed a rise in market letter writers becoming more bullish. Recent data shows that 48 percent were bullish, compared to 36 percent.

But there is another amazing resource for sentiment that works remarkably well, says Muzea. Just turn on CNBC, and listen to the advice of so-called experts. After two hours, if you're flush with enthusiasm (partially due to the hypnotic effect of those green lights that indicate the direction of the market) -- get a grip! It's most likely time to sell.

"I am thrilled that CNBC is so popular," said Muzea. "It is the greatest medium in the world for observing the trivial many."

In Muzea's world, the trivial many is just a fancy terminology to describe the popular thinking, or herd mentality.

In another "trivial-many" observation, I received an e-mail on Monday from a fund manager, with $1 billion under management, telling investors that stocks were still trading at 40 to 50 percent of fair market values. "We have stated that we expect a sudden surge back toward fair value and that we believe the move should occur before complete resolution of the Iraq war. We expect it will leave most investors behind," said the fund's chief investment officer.

What this clearly indicates is that sentiment is still too high, and the only way to be sure that stocks have hit lows is if investors want nothing to do with them. Translation: Investors have to be completely repulsed by the market and accept that stocks are set to decline for the fourth straight year.

Until then, we'll never see the bottom, says Muzea.

Opposite the trivial many, are what Muzea calls the "vital few" in the market. Just like the 80-20 rule, the vital few comprise the 20 percent who go against the grain and therefore typically get better prices. As stated above, the vital few aren't coming through with purchases in most names. In fact they're selling.

This strategy is lucidly described in Muzea's book, "The Vital Few vs. The Trivial Many." If you don't know the basics of supply and demand, short selling, or you're not familiar with the seasonally good times to invest in the market, I'd take an hour to read this book. In it are common sense observations about psychology and the market, and (my favorite) how so-called experts, more often than not, lead those who follow them into disaster.

The thrust of the book is to follow the particular insiders, like CFOs, buying or selling of stocks (unrelated to options), and go against sentiment.

Since insiders overall are selling, and the majority of sentiment measures is increasingly bullish, the Nasdaq could likely unravel and retest its October lows, according to the technique.

Bright spots: Internet and small cap names

All this said, while an overall declining market could weigh on most sectors, there is also an undercurrent of positive indicators forming in certain areas, namely small-cap companies and the Internet.

For instance, there is insider-buying activity in small-cap names suggests to Muzea that this is an area that's been neglected in this rally.

Since insiders are buying, now, they'll likely be buying when the market turns even lower. This is a very bullish signal, Muzea observed.

Here are some of Muzea's latest "buy" suggestions on small cap names based on positive insider-buying activity, or lack of selling activity.

MPC Technologies
MTCT
is a buy since the CFO and other insiders have bought shares this month in the $17 range. Insiders have a tendency to sell in the mid-20s and buy in the teens, said Muzea.

FindWhat.com
FWHT
activity shows insiders aren't willing to part with their stock despite the exorbitant run in recent months. Despite the stock hitting 52-week highs, there is no selling at these levels.

KForce
KFRC, -1.41%
and Tasty Baking
TBC
both with market caps below $100 million, have seen insider buying activity at current levels. Other companies with slightly higher market caps but with solid insider-buying include Equity One
EQY
and Trizec Properties
TRZ, -0.13%

Here is Muzea's outlook on the Internet sector.

AOL Time Warner
AOL
insider activity shows that its chief financial officer purchased a significant amount of shares at $11.82 on Jan. 31. This is what Muzea would characterize as a situation that is the positive side of neutral.

Yahoo
YHOO
activity looks even more positive, said Muzea. Insiders at Yahoo sold at lower levels in the past, but they've not been selling into strength. This suggests that insiders know that good news is coming that could help lift the stock.

Amazon.com
AMZN, -1.80%
and EBay
EBAY, -1.44%
insiders are selling into strength. But this is a normal patter, said Muzea.

Among the stocks Muzea is negative on are WebMethods
WEBM
since he spotted insider selling in February at $11, and Priceline.com
PCLN, -2.30%
which has a negative insider-activity pattern. Insiders last sold in December, said Muzea, but they've yet to come in and start buying at lower levels. This reflects lack of conviction.

Covad Communications
COVD
is disappointing, he said, because there is no insider buying at these low levels.

On Muzea's watch list are Electronic Arts
ERTS
Hotels.com
ROOM
Intuit
INTU, -2.51%
and Overture
OVER, +10.32%
These stocks, according to Muzea, have the same characteristics: Insiders have been selling and the stocks have crumbled. The next wave of insider activity will indicate whether these stocks are heading higher or lower. If insiders begin selling Electronic Arts at $60, Intuit at $39, Overture at $16 or Hotels.com at $59, this would be a negative sign, ad Muzea would go so far as shorting these stocks at the very first sign of selling.

Some stocks that had the same characteristics in the past and had fallen following an insider sale include Siebel Systems
SEBL
and Enron.

For the record, Muzea believes that after the rally runs its course, there could be another test of the lows perhaps in the May and July timeframe. But, after the lows are tested, there could be a two to three times rise in stock prices. As Muzea sees it: "The next bottom will be the bottom."

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